Friday, February 13, 2009

Mortgage Subsidies - Arguably Useless But Definitely Expensive

When Reuters yesterday released the rumor of the mortgage subsidy program, the market shot up to close unchanged after being down over 3%. But was the market, as usual, ahead of itself in its optimism? While the news of subsidies may result in some marginal benefits to the most at risk homeowners, it is at best a temporary solution as it does nothing to impact the real toxic asset overhang - the staggering notional size of unserviceable mortgage debt. Additionally, subsidies will obviously not come free. A full estimate of the program's cost can only be made once there is full disclosure on this effort (which aside from Reuters' piece, there has not been any additional confirmation from the administration), but this post attempts to give some rough preliminary indications of how much will need to be invested and whether or not the most recent plan by the administration will even be effective.

First, we present some interesting data from BAC's mortgage group, which tracks the most at-risk groups, and what current roll rates are for assorted cohorts (roll rate is the percentage of current mortgages of specific age in months that defaults within a month), emphasizing the mortgage types mostly associated with higher than usual foreclosure rates: Jumbo ARMs and Options ARMs. The conclusion is that while principal reductions have a favorable impact on reducing delinquency rates and foreclosures, the impact of interest rate reductions is much less certain and likely will have a very muted effect at best.

In the figure below, the dashed black line shows that 1.4% of 24-month Jumbo ARMs in which the borrower has little equity (>= 90% of the Loan To Value (LTV) and where monthly debt payments consumed a large proportion of income (Debt To Income, or DTI, of 45%) become delinquent within a month. The solid black curve shows that for comparable loans, but where the borrower can better afford mortgage payments (DTI of 35%) roll rates decline to 0.8%. The red lines represent borrowers with equity in the home (LTV <90%) - delinquency rates here are lower and much more insensitive to changes in monthly mortgage payments. This demonstrates a mortgage subsidy program would mostly benefit homeowners with Jumbo ARMs and little home equity. Comparing the data for borrowers who spend a large portion of monthly incomes on debt payments (dashed lines) indicates that the biggest benefit would come from principal writedown, as delinquency rates drop significantly for those homeowners who have equity in the home. The brief conclusion is that yesterday's news, even if ultimately confirmed, will be yet another step in the wrong direction by the government, which should be instead focusing on reducing the overall debt burden.

This relationship is even more pronounced when looking at the much more aggressive Option ARM mortgage data. Here the main difference is that in loans with little to no equity (DTI of 45%) there is virtually no roll rate improvement if monthly mortgage payments are made moderately more affordable (DTI dropping to 35%). Therefore, even more pronounced than in the Jumbo ARM scenario, there is no evidence that an interest rate modification program will prevent foreclosures for homeowners with Option ARM mortgages. The only sure way to reduce roll rates, delinquencies and foreclosures (at least based on empirical studies) is to enhance the equity in the mortgage, which can only be achieved via a program of debt principal reduction.

What will it cost?

Market estimates of first-lien mortgages expected to be liquidated in this economic cycle approach $2 trillion (out of $9.3 trillion in outstanding total first-lien mortgages). Assuming the new loan modification program can reach these borrowers, and the cost of lowering mortgage rates by 100 bps is 2-4 points, the total cost of the program would be $40-80 billion per 100 bps reduction. As the targeted group of homeowners currently likely has very high mortgage rates due to high DTV and LTV ratios, the program will likely need to lower mortgage rates by anywhere from 2-4%, suggesting the cost of the program could reach $300 billion (or higher), and there is no conclusive evidence it would even lower foreclosure rates. Alternatively, to effectively achieve the desired effect of lowering delinquencies, thereby lowering LTVs, the government would have to impair the $2 billion first-lien tranche, with a 50% reduction here costing $1 trillion.

Once again the government is faced with the dilemma: do the effective but expensive thing, or blow less capital on something that very well may not have an impact at all. And if the Reuters article is correct, the government will not disappoint in its continued course of consistently picking the latter option.

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Anonymous said...

Right on. One thing that has not changed and will not change is the fact that mortgage companies allow folk up to about 3 months to pay and even with lowered interest, these same folks will not be able to meet their mortgage for they are up to their heads in debt, credit card debt, new cars, etc. and this is a way of life for some and will not change. Some folk should not own a home and then they can just get up and move on...hah. For some, if one loses a job, then they lose their home and how to fix that is about the same as it always has been. Folk should not live beyond their means and put aside a few bucks for a rainey day...and most of all they should not buy a home that is way over their heads; nor should mortgage companies and banks push for such and brother, they do. They of course want to sell the most expensive thing ... and never mind you ... for the gov't covers their hides. So, the whole pic here is aghast and fraught with problems. And, no credit history is worse than being overloaded it would appear. Wow. The greed factor is everywhere. When I bought my home many a yar ago, could not afford to fix up very much of anything and used a credit card only for emergencies and bought paint (wanted wallpaper) and painted every room the same color. Hey, you know what, I sold the home and have another. Still drive an inexpensive car and live moderately and never fool with the market. Works for me. This patch on mortgages is gonna fail and need another down the lane in short time. Got to have some regulations in place.

Anonymous said...

I was hoping that someone might provide the source for the data/charts shown in the blog. In the article it mentions that the BAC mortgage group tracks this information, but I want to see if this is located anywhere publicly? I like the info presented and want to see if there is any other good info that goes along with this, or if this is it.